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Powerful income story remains in face of inflation threat
Thursday 16 Mar 2017 Author: Steven Frazer

Electricity utility National Grid (NG.) is to return a large chunk of cash to shareholders in 2017 after selling a 61% stake in its gas distribution networks.

The sum will be substantial, analysts estimate around £4bn will find its way back into the pockets of shareholders through a special dividend of something close to 85p per share. There will also be an accompanying share consolidation and £1bn share buyback.

NG - Comparison Line Chart (Rebased to first)

That payout alone would represent an 8.7% income yield, and that’s before ordinary dividends that come with a promise of RPI-linked growth for the foreseeable future. Total income next year to 31 March 2018 could be worth as much as 130.7p, for a yield of 13.4% at the current 972.9p share price.

For such a close on guaranteed return investors might well wonder why the group’s share price has not risen more sharply since the gas distribution sale was announced almost three months ago.

The simple answer is the increasing likelihood of a UK interest rate rise this year to quell returning inflation. This would act as a brake on all bond proxy-type equities, of which National Grid is one.

An aerial view of London at night, taken from within an aeroplane

Understanding National Grid

National Grid, the UK’s largest listed utility worth just shy of £36.9bn, sits in an enviable position. While increasing competition bites across the retail energy field as consumers are encouraged to switch, National Grid owns the infrastructure through which homes and businesses get their power regardless of supplier.

It’s a business that has been performing reasonably well in both the UK and US. Newish CEO John Pettigrew, who replaced Steve Holliday in March 2016, unveiled half year to 30 September results in November. These showed adjusted operating profit of £1.85bn, and adjusted pre-tax profit of £1.36m. That’s about flat on both counts versus 2015 first half figures although the rough £2.09bn of cash generated is plenty to pay the £571m first half dividend (15.17p per share) commitment and meet the interest payments on its £29.2bn of net debt.

The consensus of analyst forecasts for the full year to 31 March 2017 stands at £5.77bn and £3.04bn operating and pre-tax profit respectively, implying earnings per share (EPS) of about 64p. That implies a price to earnings (PE) multiple of 15.2, or about a 4% or 5% discount to the wider utilities sector and the FTSE All Share index.

Electricity lines carrying power across the countryside of England as the evening sun begins to set.

How big are the threats?

We have already seen the first interest rate rise in the US for about a decade. There is a strong anecdotal argument to support a similar move in the UK at some point in 2017, mainly due to the emergence of marginal inflation for the first time in years.

Between early October and early December 2016 the stock slumped 19%, neatly tying in with a rapid jump in the yield of 10 year government bonds (gilts) (yields went from about 0.75% to more than 1.4%).

The counter claim is that rising costs of living in Britain may prove temporary. ‘Our economics team sees only a 30% risk of an interest rate hike later this year,’ explain analysts at investment bank Berenberg. They believe that higher input costs due to weaker sterling may well be a relative flash in the pan, and it is highly possible that ongoing uncertainties surrounding the complex issue of Brexit could restrain the Bank of England.

Since early February gilts have softened and this tallies with a spell of strength for National Grid stock. Although arguably is not fully reflected in a share price which has edged just 6.7% higher from 911.7p lows on 1 February.

Keep an eye on the stock

As Berenberg’s analysts note, ‘if investors are convinced that bond yields will continue to rise, then National Grid is probably not the stock for them; it is more one to keep a watchful eye on.’

Selling the gas distribution stake made a lot of sense, exiting most of a maturing asset to free capital investment resources for stronger growth options in UK transmission and US operational assets. A deal with watchdog Ofgem also removes an irritation over its small UK electricity balancing business.


Ordinary dividends should yield 4.7% in the year to 31 March 2018, and that RPI-beating promise provides some level of natural hedge if inflation does hang around.

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